IGTA Journal - Autumn 2017

the easier underwriting standards. As long as home values were rising, subprime borrowers could either refinance their loans or sell their homes when the initial teaser rates expired. Thus, losses on subprime and other mortgage lending were low, reinforcing the belief that such loans were “safe.” Easier mortgage underwriting practices were also supported by the ability of mortgage originators to pool their mortgages into collateralized debt obligations (CDOs), transforming low- quality assets into triple-A-rated securities. Investors, including banks, relied too heavily on credit ratings and didn’t do sufficient due diligence on the underlying quality of the assets and the assumptions that underpinned the triple-A ratings. Implicit in these ratings was the assumption that a large, national decline in home prices was extraordinarily unlikely. The rise in home prices led to a surge in construction activity, which helped to sustain the housing boom for a time. This effect was particularly powerful in states such as Arizona, California, Florida, and Nevada. Rising home prices also bolstered the economy by supporting consumption, as households monetized these gains by cash-out refinancings and home equity lines of credit. The housing boom was also supported by an accompanying financial boom. The financing activity associated with the surge in mortgage originations and securitizations pushed up the earnings of the major banking and securities firms. These strong earnings created incentives to ease underwriting standards further. But, as housing supply responded to the increase in home prices—housing starts rose from a 1.5 million annual rate in mid-2000 to a 2.3 million annual rate in early 2006—the positive feedback loop began to run in reverse. Home prices began to soften, subprime borrowers found it more difficult to refinance, and mortgage loan defaults and delinquencies rose. As the bust got underway in earnest, residential investment declined and consumer spending was undercut as home equity levels fell. The housing boom and bust underscores several important lessons. First, the financial sector is not only a very complex system, but also one that can be inherently unstable—subject to excess, then sharp reversal. This is especially the case when an important innovation occurs and market participants don’t fully appreciate the powerful feedback loops that first sustain a boom and then contribute to a bust when the process runs in reverse. This means that we as regulators must continually evaluate the financial system and monitor the landscape for new developments and innovations that, if taken too far, could lead to excess and put the system at risk. Second, when there are potential excesses that could threaten financial stability, we should look to temper them. For example, in the run-up to the financial crisis, macroprudential tools—such as requiring larger down payments or more closely evaluating the incomes of borrowers—could have been implemented to limit the demand for housing. If such an approach were successful, home prices would not have risen so dramatically, and the subsequent bust would have been less severe. Another approach would have required financial intermediaries to build stronger capital and liquidity buffers as protection against a housing bust and an economic downturn. Prior to the financial crisis, the conventional wisdom was that asset bubbles could not be identified in real time—rather, they could only be cleaned up after they burst. While there are significant challenges to identifying asset bubbles, it is clear that cleaning up only after they burst does not always work out well in practice. Third, we need to carefully monitor the incentives that govern the behavior of borrowers, savers, and financial intermediaries. During the crisis, some examples of bad incentives that sustained the boom included: 2 / 7 BIS central bankers' speeches IGTA eJournal | Autumn 2017 | 54